Netflix And Chill Tested

| About: Netflix, Inc. (NFLX)


Before Netflix's Q4 earnings release, we posted an optimal collar hedge for it. The stock is down 11.7% since, but an investor hedged with that collar would be down 2%.

We consider a case that compares Netflix unfavorably to Amazon, and note that the "wisdom of crowds" aligns with it.

Finally, we update the status of our hedge and discuss possible courses of action for hedged Netflix shareholders.

Netflix And Chill

Before Netflix (NASDAQ:NFLX) released its fourth quarter 2015 earnings, we presented a way that shareholders could hedge their downside risk ("Netflix And Chill"). Netflix ended up beating Wall Street's consensus earnings estimate handily, posting profits of 7 cents per share versus Wall Street's estimate of 2 cents, while posting a slight miss on revenue: $1.82 billion for the quarter, versus Wall Street's estimate of $1.92 billion.

The market had something of a bipolar reaction to Netflix's earnings, driving the stock up sharply after hours when the company released its numbers after the close on January 19th, only to take back all those gains in the following day's session. The stock has slid since, down nearly 12% from when we wrote our previous article, though an NFLX shareholder hedged with the optimal collar we presented would have only been down 2% by Friday, January 29th's close. In this article, we consider the stock's prospects going forward, update the status of the hedge, and discuss possible courses of action for hedged Netflix shareholders.

Netflix, Amazon, And The S-Curve

A couple of days after Netflix posted its earnings, Seeking Alpha contributor Dana Blankenhorn posted his bearish case for the stock ("Netflix: My Short Of The Year"). In it, Blankenhorn referred to the so-called "S-Curve" used to describe the adoption of new technologies. A version of it is pictured below (image via Mastering the art of Business Planning).

Click to enlarge

After noting Netflix's strong fourth-quarter results, and praising CEO Reed Hastings' job of growing the company from a DVD rental operation to a leading TV studio, Blankenhorn offered this unfavorable comparison of Netflix to one of its streaming video competitors, Amazon (NASDAQ:AMZN):

You will ask, how can I remain bullish on Amazon yet say short Netflix? It's because Amazon has a lot more going for it than just the video service. Amazon still doesn't get a huge share of the American retail market, the cloud has just begun to hit the numbers, and there are service revenues that have just begun to grow. Amazon is at the front of the "S" - Netflix is closer to the back end.

Netflix, Amazon, And The Wisdom Of Crowds

Different analysts can come to different conclusions looking at the same financial results, and that was the case with Netflix. While Dana Blankenhorn presented the bearish case for the stock, on the same day, Seeking Alpha contributor Bill Maurer offered a more sanguine take ("Chill Over Netflix, Things Aren't That Bad"). When individual analysts disagree, it can be instructive to consider the collective view of a large number of analysts. In a previous article ("2 Screens To Avoid Bad Investments"), we referred to what New Yorker columnist James Surowiecki termed the wisdom of crowds:

Large groups of people are "smarter" than an elite few, no matter how brilliant -- better at solving problems, fostering innovation, coming to wise decisions, even predicting the future.

As we noted in that article, the wisdom of crowds is what Portfolio Armor taps into when it analyzes securities. It listens to the stock market crowd when considering a security's price action, and it listens to the option market crowd when it gauges option sentiment. Currently, the wisdom of the stock and option crowds, as measured by Portfolio Armor, supports Blankenhorn's take on Netflix versus Amazon: the site shows a potential return of 11% for Amazon versus 0.3% for Netflix. "Potential return" is our term for a bullish estimate of how a stock or ETF will perform over the next 6 months; for an explanation of how we calculate it, see our recent article on Amazon, "Amazon: Advantage Einhorn?" (note that our potential return for Amazon has come down somewhat since that article, but is still well above the potential return shown for NFLX). Let's look now at how our Netflix hedge has held up during the stock's recent slide.

Limiting Losses For Netflix Shareholders

Below, we show the original January 15th NFLX hedge and how it has cushioned the blow for hedged NFLX shareholders since.

A Closer Look At The January 15th NFLX Hedge

The optimal collar below, calculated using the Portfolio Armor iOS app, was designed to limit an investor's downside to a drawdown of no more than 7% by mid-June, while capping his potential upside at 5%. As we noted in our previous Netflix article, the potential return we had for it at the time was 3.5%, but since we could raise the cap to 5% without increasing the cost of the optimal collar, we used a 5% cap.

Note that the cost of the optimal collar above was negative, meaning the investor would have received more income from selling the call leg of his collar than he spent to buy the put leg.

How That Hedge Has Responded To NFLX's Drop

Here is an updated quote on the put leg of the collar as of 1/29.

And here is an updated quote on the call leg:

How That Hedge Protected Against NFLX's Drop

NFLX closed at $104.04 on Friday, January 15th. A shareholder who owned 1000 shares of it and opened the collar above then had $104,040 in the stock plus $10,550 in puts, and if he wanted to buy-to-close his short call position, he would have needed to pay $12,500 to do that. So, his net position value for NFLX on January 15th was ($104,040 + $10,550) - $12,500 = $102,090.

NFLX closed at $91.84 on Friday, January 29th, down 11.7% from its closing price on January 15th. The investor's shares were worth $91,840 as of 1/29 and his put options were worth $13,120, and if he wanted to close out the short call leg of his collar, it would have cost him $5,000. So: ($91,840 + $13,120) - $5,000 = $99,960. This represents a 2% drop from $102,090.

More Protection Than Promised

Although NFLX had dropped by 11.7% at the time of the calculations above, and the investor's hedge was designed to limit him to a loss of no more than 7%, he was actually down only 2% on his combined hedge plus underlying stock position by this point.

Courses Of Action For Hedged Netflix Investors

As of Friday, an NFLX investor hedged with the collar above had several possible courses of action available to him, among them these:

  1. If bearish, exit his position (stock + hedge) with a 2% loss.
  2. If more bearish, do the same as the above, except hold on to the put leg of the collar, as a bet against the stock.
  3. If neutral to bullish, stay the course.
  4. If more bullish, buy-to-close the call leg of the collar to eliminate the upside cap.

The one course of action there we would hold off on for now is 4. Even if you are a longer-term bull on NFLX, given its recent price action, we wouldn't be surprised to see it trade lower in the shorter term. And if that happens, you'll likely be able to buy-to-close the call leg for less then. We'd probably lean toward option 3. At this point, not because we're bullish on NFLX (we're not, given the potential return estimate shown above), but because this is a tight hedge (downside limited to 7% from the stock's January 15th price), and it won't expire until well after Netflix's next earnings release.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.